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Qualified retirement plans like 401(k)s and IRAs have limits for high earners. Cash value life insurance may offer tax savings and growth regardless of income.


Life Insurance: A Retirement Strategy With Tax Savings for High Earners

  • Mark Wyzgowski
  • 9/2/2014

There are almost as many ways to save and invest for retirement as there are retirees. But all of the options are not created equal, and there is one that may not always enter the conversation: life insurance. Including a cash value life policy in the mix can alleviate the drawbacks of some of the more common options, while still providing flexibility, tax-efficient growth, and income.

Limitations of 401(k)s and IRAs

Many people rely on qualified plans, such as 401(k)s and individual retirement accounts (IRAs), for their retirement savings due to the tax advantages they offer. However, these tried and true accounts come with strict limits on income and contributions, which can result in inadequate retirement savings, especially for high income earners.

The solution may be to create your own retirement income plan. This can be accomplished by accumulating cash, investing in public or private offerings (such as stocks, bonds, and mutual funds), or contributing to a life insurance policy. In recent years, more have been choosing deferred income annuities for the pension-like benefits they can produce. Each of these options comes with costs and benefits; one of the most important considerations is the tax treatment.

If you are a business owner, you can create a nonqualified deferred compensation plan that allows highly compensated employees to defer an unlimited amount of their salary and bonuses to fill the retirement funding gap. The only trouble is, as the owner of the business, you may not be able to participate due to the tax treatment of your business entity. An employer-sponsored cash balance retirement plan also offers some attractive benefits for employees and for the business.

As income tax rates increase, retirement investors are looking for solutions that allow them to make after-tax contributions that defer or eliminate future tax on those monies. They should also consider how the gain (or interest) and distributions are taxed. A Roth IRA is one solution that provides tax deferral and tax-free distributions, but there are income and contribution limits on these plans. A married couple with income greater than $191,000 is ineligible. Even those who are eligible are limited to $5,500 in annual contributions.

This is where life insurance comes in.

A Roth IRA compared to life insurance

High income individuals may be able to supplement retirement income and attempt to achieve tax efficiency with life insurance. Take a look at this comparison of the Roth IRA and a cash value life insurance policy.

Feature Roth IRA Life Insurance
Contribution limits Yes No
Tax-favored withdrawals Yes Yes
Tax-deferred accumulations Yes Yes
Tax-free death benefit No Yes
Penalty for early withdrawal Yes Possibly
Cost of insurance charges No Yes
Market risk Possibly Possibly

Life insurance allows the policy owner to contribute amounts up to an insurance company limit, or limits that would cause the policy to be considered a modified endowment contract, which is taxable under federal law. The cash value of the policy grows tax deferred, and when the income is needed, the policy owner can make tax-free withdrawals of the reportable cost basis. With many policies, the policy owner can also take loans against any gains. The loans are not taxable at the time they are taken, but will reduce the death benefit by the amount of the loan, plus any interest.

One pitfall to this strategy is that if the policy owner takes out all the cash value of the contract and the policy lapses, all of the loans will be taxable in the year the policy ends. To compensate for that risk, the insurance industry has created riders to limit the amount of contract values that can be taken out as loans. These features will essentially freeze the policy, but still allow it to stay in force until the death of the insured.

Collecting the life insurance death benefit

The death benefit of a life insurance policy can be the self-completing mechanism of the retirement income plan if the insured person passes away. The death benefit will be greater than the cash value of the contract for the majority of the policy’s lifetime. If the death benefit is exercised, the proceeds can provide retirement income to the surviving spouse and family, and additional dollars to assist with current financial needs.

Another planning consideration is who to insure. In many cases, it is appropriate to have both spouses insured on separate policies. However, in some cases, covering husband and wife together may create the greatest policy efficiency and enhance the income potential. Ownership of a policy is an important consideration since an individually owned policy could be included in your taxable estate. Even so, in most states, some or all of a life insurance policy’s cash value and death benefit may be protected from creditors.

Filling the retirement funding gap

It’s important to look at each individual situation carefully to determine if life insurance planning is a good way to address a void in retirement funding, and if it can be crafted to provide income and tax efficiencies. Of course, you should always start with a vision of what you want to do in your retirement, and a careful assessment of your financial situation. Consult an investment advisor and tax consultant to analyze your needs and the corresponding risks.